Finance

Question 1

Capital Budgeting - Buy vs Lease

Answer 1

Calculate NPV of each option and compare to determine which option is cheapest
* NPV of buy option – consider:
o Cost of asset
o PV of tax shield
o Maintenance costs

• NPV of lease option – consider:
  o PV of after tax lease payments
• Other factors to consider:
  o Impact on covenants
  o Cash flows (leasing lessens the current cash burden)
  o Leasing may be easier to come by if company has trouble obtaining financing
  o Purchasing the asset might provide more flexibility (ownership of asset)
  o Leasing might insulate company from severe declines in asset value
  o Possible tax advantages (no capital leases for tax purposes – CRA sees all leases the same so cash payments would be deductible, however no CCA)

Question 2

Financing Options – Debt vs. Equity

Answer 2

• Debt financing options:
  o Loan- consider loan term, and security/collateral required
  o Lease
  o Government assistance
• Equity financing options:
  o Angel investors- can be friends or family looking for a return on investment; generally passive investors
  o Venture capitalists- professional investment funds, looking for superior returns (>30%); active participants in management, with a clear exit strategy
  o Private equity- tends to participate later in business lifecycle, hence lower risk
  o Public markets

Question 3

Incremental Cash Flows

Answer 3

• Incremental cash flows comprise the additional cash flows from taking on a new project, incorporating the tax-affected initial outlay, annual revenues & expenses and terminal value (or cost) associated with the project, in accordance with the scale and timing of the project
• When determining incremental cash flows from a new project, consider:
  o Sunk Costs – These are the initial outlays that cannot be recovered even if a project is accepted. As such, these costs will not affect the future cash flows of the project and are not considered incremental
  o Opportunity Costs – These represent any potential loss of current cash flows due to accepting a new project and are considered incremental
  o Cannibalization – This is the opportunity cost where a new project takes sales away from an existing product
  o Working Capital Changes – These represent changes in receivables, payables and inventory due to accepting a new project and are therefore considered incremental

Question 4

Net Present Value (NPV) vs. Internal Rate of Return (IRR)

Answer 4

• The NPV rule states that you invest in any project which has a positive NPV when its cash flows are discounted at the opportunity cost of capital, also known as the discount rate (usually the cost of raising the capital to fund the project)
• The IRR rule states that you invest in any project offering a rate of return which exceeds the opportunity cost of capital
• A project’s rate of return is calculated as the discount rate at which the NPV of the project would be zero
• Therefore, the NPV and IRR rules should give the same accept/reject answer about a project, in most circumstances
• A project’s cash flows should include incremental elements only (i.e. additional sales, associated expenses, lost margin on cannibalization, investment & associated tax-shield, etc., but no financing elements, as discounting of the cash flows already addresses financing)

Question 5

Discounted vs. Undiscounted Cash Flows

Answer 5

• Incremental cash flows (excluding financing elements) should be discounted to recognize the time value of money for the purposes of making a decision regarding accepting or rejecting a project
• Incremental cash flows (including financing elements) should be analyzed year over year, without discounting, to determine if a certain cash position would be met by a certain time

Question 6

Payback Period

Answer 6

• Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment
• In general, investments with lower payback period are preferred
• To determine, calculate the cumulative net cash flow for each period and then use the following formula for payback period:
  Payback Period = A + B / C, where:
  o A is the last period with a negative cumulative cash flow;
  o B is the absolute value of cumulative cash flow at the end of the period A; and
  o C is the total cash flow during the period after A.

Question 7

Business valuation – Asset-based approach

Answer 7

• To decide which asset-based valuation approach to apply, we must first determine whether the entity is a going concern.
• If the entity is NOT a going concern, a Liquidation approach must be used
  o Net realizable value will depend upon whether or not there is a “forced” sale, or orderly liquidation
• If the entity IS a going concern, and the entity does not maintain active operations, the Adjusted Net asset approach may be appropriate
  o Assets are valued at fair market value, net of disposition and tax costs
  o Liabilities are paid

Question 8

Business valuation – Income-based approach

Answer 8

• If the entity IS a going concern, and the entity maintains active operations and “excess earnings”, an income-based valuation approach may be appropriate
• Capitalized cash flow approach- where the entity has consistent cash flows that are reflective of future earnings considering:
  o Maintainable (normalized) EBITDA
  o Sustaining capital reinvestments
  o Capitalization rate/multiplier
  o Income tax shield
  o Redundancies
• Discounted cash flow approach- where the entity is in the start up stage
• Market based approach- where there is publicly available comparative information available

Question 9

Derivative Instruments

Answer 9

Two common risks are foreign currency risk and interest rate risk. Derivatives can be used to hedge and mitigate those risks.
* Foreign currency risk: Hedge with a forward contract, future contract or options
o Forward: A contract to buy or sell a fixed amount of foreign currency dollars at a set future date. If hedging a future sale in foreign currency, then the entity would use the proceeds from the sale to settle the forward contract, fixing the amount of CDN dollars to be received from the sale.
o Future: A contract to buy or sell a fixed amount of foreign currency dollars at a set future date. Similar to forward contracts, but they are sold in fixed amounts with fixed maturity dates, so cannot match the timing and amount of the entity’s transactions exactly.
o Options: Purchase options to buy or sell foreign currency dollars at a certain price at a set future date. The entity has the right, not the obligation, to settle when the option matures.
* Interest rate risk: Hedge with an interest rate swap contract
o Usually entered into with a bank, and has the effect of converting a variable rate loan into a fixed rate loan.